Why Democracies Default

As the situation in Greece unfolds, it's easy to believe that the country will soon be forced into default much like an illiquid and/or insolvent company would be under similar circumstances. The Greek leadership will simply get up one day to discover that its checks from the day before have bounced. It will then have no choice but to march down to the local courthouse with bankruptcy petition in hand.

Yet the reality is that countries don't go broke in the same sense that a firm or a company might. They don't go out of business, in other words, as they can generally repay foreign creditors given enough pain and suffering on the domestic front. The decision turns instead on a country's willingness to pay and not its ability to do so. Lest you have any doubts, according to data compiled by Carmen Reinhart and Kenneth Rogoff for the study "This Time is Different," more than half of defaults by middle-income countries between 1970 and 2008 occurred when the afflicted country's debt service payments were handily sustainable.

So why do countries choose to default when they could otherwise pay off their debts? The answer is simple: It's easier. To illustrate why, I've chosen to take a look at Romania's experience in the 1980s, as it's the only modern country to fully satisfy an otherwise onerous foreign debt burden without resorting to actual default, constructive default via inflation, or some type of debt restructuring. And as you'll see, the decision to do so turned out to be a fateful one for Romania's leader and his wife.

A leader's silent war on his people
Romania borrowed heavily throughout the 1970s to finance the modernization of its energy sector. Its goal was to become one of Europe's principal suppliers of secondary petroleum products. Unfortunately, the decision to pursue this course couldn't have come at a worse time, as the new capacity came on line just in time to see the price of oil triple after the Iranian revolution. Because the price of secondary oil products failed to rise proportionately, moreover, Romania proceeded to lose $25 on every ton of refined products it sold to the West. And by 1980, the country was posting a record $1.5 billion trade deficit -- a non-negligible amount for a country of Romania's size.

To avoid defaulting on its now-quaint $11 billion foreign debt, the country's Soviet-style leader Nicolae Ceausescu chose the path of austerity in 1982, initiating what came to be known as his "silent war" against the people. His plan was to pay off Romania's debts in eight years by turning its aforementioned trade deficit into a trade surplus. Doing this, however, required two things. In the first case, the country had to minimize imports by reducing internal demand for them. And in the second case, it had to maximize exports of domestically produced goods such as energy and agricultural products. Ceausescu accomplished both (see the figure below) by rationing basic amenities such as heating fuel in the winter and basic foodstuffs throughout the year.

Source: International Monetary Fund's 2011 World Economic Outlook Database.

Although these measures were ultimately successful -- Romania's foreign debts were paid off by 1989 -- the resulting carnage left many wondering whether it was worth it. In addition to a purported 15,000 deaths a year from freezing and malnutrition due to the rationing, Romania's economy collapsed into an economic malaise worse than that of the Great Depression. From peak to trough, its GDP began a staggering 67% descent in the latter years of Ceausescu's regime. And it didn't regain its 1988 high until 16 years later in 2004 -- a mere five years before it collapsed again in the midst of the Great Recession. Not to put too fine a point on it, but both Ceausescu and his wife were ultimately tried and executed for these transgressions.

The lessons of Romania's austerity
In light of Romania's experience, it should be no surprise that the governments of heavily indebted European countries are buckling under the pressure of the continent's debt crisis. Italy's fell last November when its elected prime minister was replaced by a nonelected technocrat known as Il Professore ("The Professor"). Greece's fell the same month when a similarly nonelected technocratic banker assumed the reins. And Romania's fell again earlier this month after its prime minister submitted his resignation, citing the need to "defuse political and social tension" over a new round of austerity cuts.

The lesson is that extreme austerity measures are simply not sustainable without an unelected autocratic leader who's willing and able to subjugate the will of his people in favor of creditors abroad. And it's for this reason that I fervently believe most if not all of Europe's heavily indebted countries will eventually default in one form or another. Indeed, despite their assertions to the contrary, it's no longer a question of if, but rather when.

Foolish bottom line
With this in mind, I'd advise investors to steer clear of European stocks for the time being. According to my colleague Alex Planes, betting on companies like the National Bank of Greece (NYSE: NBG  ) and Greek shipper DryShips (Nasdaq: DRYS  ) is akin to making a dead cat bounce -- not a pretty picture, in other words.

A much better alternative would be a company like Procter & Gamble (NYSE: PG  ) , which I've recommended separately to first-time and seasoned investors. Or you could follow the prescient advice of our senior financial analyst Anand Chokkavelu who recommended Ford (NYSE: F  ) as his one stock to buy last December or even the thriving office supplies retailer Staples (Nasdaq: SPLS  ) , which he recommended as his one stock to buy in January.

Finally, if none of these wet your whistle, then you might be interested in our recently released free report "The Motley Fool's Top Stock for 2012." It details an under-the-radar company that we believe is about to hit it big. To access a copy of this free report, click here now.

Foolish contributing writer John Maxfield does not have a financial position in any of the companies mentioned above. The Motley Fool owns shares of Staples and Ford Motor. Motley Fool newsletter services have recommended buying shares of Staples, Ford Motor, and Procter & Gamble. Motley Fool newsletter services have recommended creating a synthetic long position in Ford Motor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (64)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 23, 2012, at 5:23 PM, DJDynamicNC wrote:

    If the alternative to defaulting is killing off thousands of your own citizens and destroying your economy, any responsibile government should hasten to put the interests of its citizens before those of bondholders.

    People first.

    In fact, take a look at what happens when they do:

    http://www.bloomberg.com/news/2012-02-20/icelandic-anger-bri...

  • Report this Comment On February 23, 2012, at 5:53 PM, mDuo13 wrote:

    Great article, and a good reminder that there are more important things out there than current events and balanced budgets.

    We have the idea of bankruptcy today because it's a lot better for society than debtors' prisons and the like. Creditors are like investors: they should follow through on their due diligence and make sure the money they're investing is a good proposition in the long term. Any loan sharks who try to beat the system otherwise can and should be ready to face the loss of their money if their bets came up bad.

  • Report this Comment On February 23, 2012, at 6:17 PM, MartyTheCanuck wrote:

    The people from Eastern Europe suffered a great deal during the Communists years. Thanks to Reagan, John Paul II, Lech Walesa, and countless dissidents, they gain their freedom eventually.

    Now the lesson I get from the article is don't lend money to governments. They might not repay, even when they can. Or people elect someone that promises hope and change, when in fact it's even more of the same, until the country is broke and lenders lose.

    Invest in great companies. Even if you make mistakes, most of your investments will thrive...

  • Report this Comment On February 23, 2012, at 6:54 PM, Darwood11 wrote:

    @MartyTheCanuck,

    The lesson I get from all of this is "never trust the polticians" or the "political class" as I prefer to call it.

    Just today Pres. Obama was making comments about "plan 1,2,3, is to drill, drill, drill," His plan is to pump billions into green technology. The problem? We drive our cars by purchasing fuel derived from gasoline. Any prudent planner would create a migration plan. Have any of us in America ever heard a politician describe a succinct, and intelligible "migration plan" from oil to some other source of energy with a timetable, year by year?

    Nope, and I guarantee you never will from the "political class."

  • Report this Comment On February 23, 2012, at 8:10 PM, CaptainWidget wrote:

    Austerity in this sense really just means "sacrificing the people for the sake of the government". The Romanian government didn't get smaller, it got bigger by taking more from the people.

    In that sense, no austerity doesn't work. True austerity from the government however would require sacrifices and real net dollar cuts to their budget. The problem with bureaucracies however is you put someone in power who determines their own pay, it's impossible for them to legislate themselves a pay cut. So we get situations like Greeces, or Romania, or America. Corrupt politians voting themselves largess out of the pockets of the taxpayers....and then occassionally starving them to death when the debts get out of control.

    True austerity will only come from returing the capital and means of production to the free market and private citizens.

  • Report this Comment On February 24, 2012, at 8:48 AM, Merton123 wrote:

    Excellent Report John.

    Proctor and Gamble share price has gone up $2 during the last few days. I believe that reversion to the mean will create lower returns for American Stocks and higher returns for European Stocks over the next two years. Eastern Europe is in the process of rebuilding infrastructure and becoming a part of Western Europe. The USA economy is a mature economy with smaller growth opportunities.

  • Report this Comment On February 24, 2012, at 9:31 AM, TMFGortok wrote:

    It's only 'austerity' if people have grown dependent on the government. That happens when the government starts promising a free lunch (or socializing the cost of lunch -- a la Social Security), and people aren't smart enough to realize two things:

    1) These programs are not fiscally sustainable (if they were, the businessmen would jump at the chance).

    2) In a democracy, the only way to pay for these programs in the long run is through inflation, which itself is a tax on savers (thereby exacerbating the problem). You can't pay for these programs through continued taxing (people will elect someone who will lower their tax burden), and you can't continually borrow from foreign nations (sooner or later, they won't lend you any more money).

    People say, "Austerity is a bad thing." It is, if you think a good thing is a society dependent upon government.

  • Report this Comment On February 24, 2012, at 10:15 AM, FUDweiser wrote:

    excellent article.

  • Report this Comment On February 24, 2012, at 10:21 AM, Mickum wrote:

    I don't know if anyone is addressing the larger issue here. If governments weren't in the economy business and social services business (and absent a horrific war), there likely would be no debt problem and, therefore no default problem.

    Why do we assume that government controlling business (investing heavily in "modernization") is a good idea or the way we should do business?

    Let's leave the economy to the corporations, small businesses and individuals. That's why we have a GDP of 15 trillion dollars. It's called the creation of wealth.

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